The EBS is on the block and there have been countless headlines regarding the idea that debts might get written down by Wilbur Ross if the Cardinal Capital group (who he is backing) are the successful bidder. I have said that I doubt this will happen and will set out why in this post.
EBS carried out a PCAR (prudential capital assessment requirement) test in March 2010, it showed that they required €875 million in funding to come up to scratch. Thus far they received €100m in cash from the state and a further €250m in a promissory note leaving a gap of €525m to fill. The bids being touted are in the region of €550m meaning that whoever buys in is effectively bridging the gap and paying a small premium as well.
Take a look at a balance sheet and you’ll see that no matter what happens, that in the end assets=liabilities. That is an accounting identity, in our example we have a hypothetical bank which has assets and liabilities worth (for example sake) €100 million Euro.
In a balance sheet of a bank the loans are the assets and things like equity, deposits and bonds are all the liabilities. Banks are unique in this respect, the deposits which they need are liabilities (obligations) of the bank, used to create loans (liabilities to other parties) which become the assets.
So if you were to ‘write down’ loans you are reducing the value of the assets, we’ll say that there is a write down of 20% on loans and that in this bank there are only bog standard €200,000 loans, 500 in total and they all started on the same day (naturally it doesn’t really work this way but this is just to make the point).
So now you have assets worth less than the liabilities, and assets always equals liabilities, so your choice is to either create unfunded loans out of thin air (impossible), or get free assets via the state (the Irish version of capitalism) or reduce liabilities in line with the reduced asset value. How does that happen?
There is a hierarchy, an order in which the liabilities are eradicated and it is shown in broad terms below.
What happens is that the blue bit at the top (equity) is eradicated first, then it goes down the line of creditors. The people bidding for EBS are NOT stating that they are going to burn bondholders or any other bank creditor and therein lies the ruse, because it means they can’t write down debt without using what is effectively an accounting trick (I’ll cover equity stakes in property in a later blog).
As you can see, if you write down the assets, the first in line to take the hit will be the equity holders, and the parties bidding for EBS are bidding for 70% equity in the building society. So a write-down [in the traditional sense] would merely wipe out the equity stake that they have just paid so dearly to take.
The only way this could occur otherwise is if the write downs were on such a small level that they didn’t affect the balance sheet (in which case the promise of writing down debts in insincere), or it is via accounting tricks (equity stakes), or if there is further government assistance that the rest of us don’t know about in the pipeline.
The reason that they are able to do this in the USA is that mortgages sold are in packages where they are valued at 20c on the Dollar, so when you buy them you can afford to let the borrowers know that they now owe only 50c on the Dollar and you give them a new interest rate or other terms and conditions, in our hypothetical bank that would mean that mortgages were now all €100,000 instead of €200,000. The EBS isn’t being sold on that basis, so this can’t happen, and thus it is the reason for my rather sceptical views on ‘mortgage debt relief’ any time soon.